JULY 2006
After considering over 70 comment letters on its proposing release that was published for comment in October 2005
(the “Proposing Release”),
1
on July 18, 2006, the Securities and Exchange Commission (the “Commission”) issued an interpretive release (the “Interpretive Release”) with respect to client commission practices under Section 28(e) of the Securities Exchange Act of 1934.
2
This constitutes the Commission’s fourth interpretive release under
Section 28(e) over the past 30 years.
The Interpretive Release replaces Sections II and III of the Commission’s 1986 interpretive release (the “1986
Release”), which give guidance on third-party research and the meaning of “brokerage and research services” in
Section 28(e), but is not intended to replace any other section of the 1986 Release.
3
This client alert highlights the differences between the Interpretive Release and the Proposing Release and summarizes the framework for analyzing whether a money manager may avail itself of the Section 28(e) safe harbor. Although the new interpretations will be effective prospectively upon publication in the Federal Register, money managers may continue to rely on the 1986 Release for another six months. Exhibit A to this alert contains examples of eligible and ineligible research and brokerage products and services under the Interpretive Release. Exhibit B contains a flowchart of the analysis that must be employed in determining whether a particular product or service satisfies the conditions of Section 28(e).
BACKGROUND
As fiduciaries, money managers must act in the best interest of their clients, may not use client assets for their own benefit without client consent, and are obligated to obtain best execution of client transactions. Section 28(e) provides a safe harbor to protect a money manager from a breach of fiduciary duty claim under federal or state law if the money manager paid commissions to one broker-dealer that were higher than commissions charged by another broker-dealer for the same transactions. Similarly, Section 28(e) protects a money manager from allegations of a breach of fiduciary duty if it used client commissions to obtain research rather than use the money manager’s own assets to cover the research expenses. The Interpretive Release states that if a money manager does not satisfy the conditions of Section 28(e), it is not necessarily in breach of its fiduciary obligations solely because client commissions paid were not the lowest available commission rate for products and services provided by the brokerdealer. The Interpretive Release also reminds broker-dealers of potential aiding and abetting liability where a broker-dealer knows that a money manager has represented to its clients that it will operate solely within Section
28(e) but requests the broker-dealer to pay for products or services that are not eligible under the safe harbor.
1
Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, Commission Release No. 34-52635 (Oct. 19, 2005) (hereinafter
“Proposing Release”).
2 Commission Guidance Regarding Client Commission Practices Under Section 28(e) of the Securities Exchange Act of 1934, Commission Release No. 34-54165 (July 18, 2006).
3
Commission Release No. 34-23170 (Apr. 23, 1986).

HIGHLIGHTS OF CHANGES FROM PROPOSING RELEASE
The Interpretive Release does not deviate substantially from the Proposing Release, but clarifies or modifies prior interpretations of the safe harbor in the following important respects:
ƒ Commission-Sharing Arrangements . The Interpretive Release takes a broader approach to commissionsharing arrangements than the Proposing Release regarding when a broker-dealer is deemed to be
“effecting securities transactions” under the safe harbor and when research services are “provided by” a broker-dealer that effects transactions.
ƒ Mass Marketed Publications. The Interpretive Release clarifies that “mass-marketed publications” are not eligible as research products under Section 28(e). This will primarily exclude widely circulated newspapers and magazines. This interpretation restores a Commission position in 1976 that excluded certain products that were otherwise available and offered to the general public on a commercial basis from being considered “research” for Section 28(e) purposes.
ƒ Proxy Voting . The Interpretive Release explicitly states that research or advice on how to vote proxy ballots falls outside of Section 28(e) because these products or services do not provide the money manager with “lawful and appropriate assistance” in making investment decisions.
ƒ Order Management Systems . The Interpretive Release reversed the Commission’s position in the
Proposing Release in which it instituted a blanket exclusion of order management systems (“OMS”) as eligible brokerage.
FRAMEWORK FOR ANALYZING “BROKERAGE AND RESEARCH SERVICES”
The Interpretive Release reaffirms that the analysis of whether a money manager may rely on Section 28(e) entails a
3-step process:
ƒ determination of whether the product or service falls within the statutory limits of Section 28(e)(3) (i.e., whether it is eligible “research” under Section 28(e)(3)(A) or (B), or eligible “brokerage” under Section
28(e)(3)(C));
ƒ determination of whether the eligible product or service actually provides “lawful and appropriate assistance” to the money manager in the performance of its investment decision-making responsibilities; and
ƒ good faith determination that the amount of client commissions paid is reasonable in light of the value of products received or services rendered.
ELIGIBLE RESEARCH
Eligible research under the safe harbor is restricted to “advice,” analyses,” and “reports” within the meaning of
Section 28(e)(3) that reflect the expression of reasoning or knowledge relating to the subject matter identified in the
Section 28(e)(3)(A) and (B).
4
Examples of eligible research include: traditional research reports, discussions with research analysts, meetings with corporate executives to obtain oral reports on the performance of a company, seminars or conferences that provide substantive content relating to the subject matter in the statute (e.g., issuers, industries, securities), software that provides analyses of securities portfolios, and analytics available through OMS.
The Interpretive Release focused on five types of products and services that the Commission believed warranted further clarification: mass-marketed publications, inherently tangible products and services, market research, data and proxy services.
4 Research that constitutes “advice” must be related to the value of securities, the advisability of investing in, purchasing, or selling securities, or the availability of securities or purchasers or sellers of securities. “Analyses” or “reports” must relate to issuers, industries, securities, economic factors and trends, portfolio strategy, or the performance of accounts.

Mass-Marketed Publications
The Interpretive Release clarifies that mass-marketed publications fall outside the protection of Section 28(e).
“Mass-marketed publications” are defined as publications intended for and marketed to a broad, public audience.
The Interpretive Release distinguishes mass-marketed publications from materials that are marketed to a narrow audience, directed to readers with specialized interests, and have high cost. Although the Interpretive Release did not name publications that may be eligible as research, it did note that financial publications that are not targeted to a wide public audience, trade magazines and technical journals covering specific industries or product lines may be eligible as research if they are marketed and intended to serve the interests of a narrow audience. The manner in which a publication is distributed (i.e., via mail vs. electronically) would not affect the determination of whether it is mass-marketed. That is, if a publication is marketed to a narrow audience but is accessible on the Internet by the general public, the publication may still be eligible as research under the safe harbor.
Tangible Products and Services
Products or services that do not reflect the expression of reasoning or knowledge (e.g., products with inherently tangible or physical attributes) are not eligible as research under Section 28(e). Computer hardware, computer accessories, peripherals and delivery mechanisms associated with computer hardware or associated with the oral delivery of research are all outside of the “research services” safe harbor. Although certain tangible products and services may not qualify as “research” under Section 28(e), they may be eligible under the safe harbor as brokerage products if they relate to trade execution and satisfy the temporal standard discussed below.
Market Research
The Commission clarified in its Interpretive Release that market research is eligible under Section 28(e) if it otherwise satisfies the standards for research. Market research that may be eligible under the safe harbor includes pre-trade and post-trade analytics (including trade analytics transmitted through OMS), software, and other products that depend on market information to generate market research. Advice on order execution, execution strategies, market color, and availability of buyers and sellers also is eligible “research” under Section 28(e).
Data
Data services, such as those that provide market or economic data, may be eligible as “research” so long as they satisfy the subject matter criteria and provide lawful and appropriate assistance in a money manager’s investment decision-making process. Market data, including stock quotes, last sale prices, and trading volumes constitute
“reports concerning securities” and are eligible as research services under Section 28(e). Other data that reflects the expression of reasoning or knowledge related to the subject matter identified in the statute may be eligible under the safe harbor (e.g., unemployment and inflation rates or gross domestic product data).
Proxy Services
The Interpretive Release clarifies that proxy services that assist a money manager in deciding how to vote proxy ballots and products or services that handle the mechanical aspects of voting do not provide “lawful and appropriate assistance” to the money manager in making its investment decisions. However, other proxy services and products may constitute eligible research under the safe harbor, including reports and analyses on issuers, securities and advisability of investing in securities. To the extent that a product or service is used for investment decision-making and in connection with voting, it should be treated as a mixed-use item under the safe harbor.

ELIGIBLE BROKERAGE
Temporal Standard
Activities required to effect securities transactions, functions incidental thereto, and functions required by
Commission or SRO rules are eligible as “brokerage” under the safe harbor. The Interpretive Release preserves the proposed temporal standard which limits eligible brokerage to products and services that relate to trade execution from the point at which a money manager communicates with the broker-dealer for the purpose of transmitting an order for execution, through the point at which funds or securities are delivered or credited to the advised account.
Therefore, communications services related to execution, clearing and settlement of securities transactions and other functions incidental to effecting securities transactions (i.e., connectivity service between the money manager, broker-dealer and other parties such as custodians) are eligible as brokerage under the safe harbor. Trading software used to route orders to market centers, software that provides algorithmic trading strategies, and software used to transmit orders to direct market access systems also may satisfy the temporal standard and qualify as brokerage under Section 28(e).
Ineligible Overhead
Products and services that are part of the money manager’s cost of doing business (i.e., “overhead”) are ineligible for protection under Section 28(e). Hardware (e.g., telephone or computer terminals) is identified as overhead in the
Interpretive Release and is deemed ineligible under the safe harbor since it is not sufficiently related to execution.
Money managers are also prohibited from using client commissions for products or services that assist them in meeting their compliance responsibilities, such as compliance tests to analyze the quality of brokerage executions.
Error correction trades or related services are also outside of the safe harbor since they are deemed to be separate transactions to correct the money manager’s error and are not made to benefit the advised account.
Custody
Many clients leave their securities with their brokers, which provide custody as part of the brokers’ execution services for no additional charge. Based on the language of Section 28(e) and industry practice, some money managers have used client commissions to pay for custody services that the money managers were obligated to provide under their client agreements. The new interpretation will prohibit that practice.
The Interpretive Release limits the scope of the Section 28(e) safe harbor to custody that is incidental to effecting securities transactions. Short-term custody relating to effecting particular transactions, and clearance and settlement of those trades is interpreted to fall within the statute since it is tied to processing the trade between the time the order is placed and settlement. However, long-term custody and custodial recordkeeping services that are provided in connection with accounts after clearance and settlement are treated as not incidental to effecting securities transactions and will not be eligible brokerage services under Section 28(e).
Order Management Systems
The Interpretive Release clarifies that certain functionality provided through OMS may be eligible brokerage or research. Aspects of OMS that may be eligible brokerage include: dedicated lines between the broker-dealer and the money manager’s OMS; lines between the broker-dealer and OMS operated by third-party vendors; and trading software used to route orders, provide algorithmic trading strategies or transmit orders to direct market access
(“DMA”) systems or provide connectivity to this software.
LAWFUL AND APPROPRIATE ASSISTANCE
The Interpretive Release reaffirms that eligible research and brokerage products and services must provide the money manager with “lawful and appropriate assistance” in carrying out its investment decision-making responsibilities. Whether a product provides “lawful and appropriate assistance” is determined on how the eligible product or service is used by the money manager.

Mixed Use Items
If a money manager uses a research product or service for both research and non-research functions, the money manager must make a reasonable allocation of the cost of the product according to its use (i.e., the percentage of the product that provides assistance to the investment decision-making process may be paid with client commissions whereas the other non-research portion must be paid with hard dollars). Money managers must maintain adequate records of these allocations to make a good faith determination that the amount paid for the mixed-use item in client commissions was reasonable in relation to the value of the research product or service received.
GOOD FAITH DETERMINATION AS TO REASONABLENESS
Section 28(e) requires that money managers seeking to comply with the safe harbor make a good faith determination that the commissions paid are reasonable in relation to the value of brokerage and research services received, either in terms of the particular transaction or the money manager’s overall responsibilities for discretionary accounts. The
Interpretive Release reiterates that a money manager that uses client commissions to pay for products or services that were copied, repackaged or aggregated must make a good faith determination that any additional commissions paid for such services were reasonable. If a broker-dealer also offers its research for an unbundled price, the price should assist the money manager in making its good faith determination.
THIRD-PARTY RESEARCH AND COMMISSION-SHARING ARRANGEMENTS
Section 28(e) is available only where the broker-dealer that receives commissions “effects” the money manager’s trades and “provides” the research. In the context of third-party research and commission-sharing arrangements, the
Interpretive Release relaxes its position in the Proposing Release as to what functions an executing broker-dealer must provide in order to “provide” the research and what services an introducing broker-dealer must provide in order to “effect” the money manager’s trade. The Interpretive Release emphasizes that Section 28(e) applies equally to arrangements involving client commissions paid for proprietary research, as well as third-party research arrangements where the research services and/or products are developed by third parties and “provided by” a brokerdealer that participates in effecting the transaction.
“Provided by” Requirement
In order for a broker-dealer who effects transactions to be deemed to “provide” research, it must either:
(i) prepare the research; (ii) be financially obligated to pay for the research; or (iii) pay the research preparer directly and take steps to ensure that the services paid for with client commissions are within Section 28(e).
5
Such steps would include: (a) reviewing the description of the services to be paid for with client commissions under the safe harbor for red flags that indicate the services are not within Section 28(e) and agree with the money manager to use client commissions only to pay for those items that reasonably fall within the safe harbor, and (b) developing and maintaining procedures to ensure that research payments are documented and paid for promptly.
“Effecting Securities Transaction” Requirement
In the Proposing Release, the Commission stated that where more than one broker-dealer receives commissions, an introducing broker must: (1) be financially responsible to the clearing broker-dealer for all customer trades until the clearing broker-dealer has received payment or securities; (2) make and/or maintain records relating to its customer trades required by Commission or SRO rules; (3) monitor and respond to customer comments concerning the trading process; and (4) generally monitor trades and settlements. The Interpretive Release modifies the “effecting securities transactions” requirement with respect to client commission-sharing arrangements by clarifying that a broker-dealer is deemed to have “effected” the trade if it: (i) executes, clears or settles the trade; or (ii) performs one of the four aforementioned functions and reasonably allocates the other functions to another broker-dealer in a manner fully consistent with its obligations under SRO and Commission rules.
5 This presumably relaxes the Commission’s “normal and legitimate correspondence” relationship requirement, and obligates the broker-dealer to determine that the research is within the safe harbor.

CONCLUSION
The Interpretive Release is not retroactive and will be effective upon publication in the Federal Register. Money managers may rely on either the Commission’s 1986 Release or on the Interpretive Release for a period of six months after publication. The Commission is expected later this year to propose requirements for disclosure and recordkeeping of client commission arrangements.
The Commission announced that it welcomes additional comments on client commission arrangements and may supplement the Interpretive Release if it determines that additional guidance is appropriate.
Michael S. Caccese mcaccese@klng.com
617.261.3133
Christina H. Lim clim@klng.com
617.261.3243
If you have any questions or would like more information about K&LNG’s Investment Management Practice, please contact one of our lawyers listed below:
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EXHIBIT A
EXAMPLES OF ELIGIBLE AND INELIGIBLE RESEARCH AND BROKERAGE PRODUCTS AND SERVICES
ELIGIBLE RESEARCH*
ƒ Traditional research reports analyzing the performance of a particular company or stock
ƒ
Discussions with research analysts
ƒ
Meeting with corporate executives to obtain oral reports on the performance of a company
ƒ Seminars or conferences
ƒ Software that provide analyses of securities portfolios
ƒ
Corporate governance research (including corporate governance analytics) and corporate governance rating services
ƒ
Consultant advice with respect to portfolio strategy
ƒ Financial newsletters and other financial and economic publications that are not targeted to a wide, public audience
ƒ
Trade magazines and technical journals concerning specific industries or product lines that are marketed to, and intended to serve the interests of a narrow audience
ƒ Pre-trade and post-trade analytics
ƒ Software and other products that depend on market information to generate market research, including research on optimal execution venues and trading strategies
ƒ
Advice from broker-dealers on order execution, including advice on execution strategies, market color and availability of buyers and sellers (and software that provides these types of market research)
ƒ
Market data, including stock quotes, last sale prices, and trading volumes, company financial data and economic data (e.g., unemployment, GDP figures)
ƒ Reports and analyses on issuers, securities and the advisability of investing in securities that are transmitted through a proxy service
* Eligible only if the product or service relates to the subject matter specified in Section 28(e).
INELIGIBLE RESEARCH
ƒ Consultant services relating to the managers’ internal management or operations
ƒ
Mass-marketed publications
ƒ
Computer hardware (e.g., computer terminals)
ƒ
Computer accessories
ƒ Peripherals and delivery mechanisms associated with computer hardware or associated with oral delivery of research (e.g., telecommunication lines, transatlantic cables, computer cables).
ƒ
Expenses for travel, entertainment and meals associated with attending seminars
ƒ Travel and related expenses associated with arranging trips to meet corporate executives, analysts or other individuals who may provide eligible research orally
ƒ
Office equipment, office furniture and business supplies
ƒ
Salaries (including research staff)
ƒ Rent
ƒ Accounting fees and software
ƒ
Website design
ƒ
E-mail software
ƒ
Internet service
ƒ Legal expenses
ƒ Personnel management
ƒ
Marketing
ƒ
Utilities
ƒ
Membership dues (including initial and maintenance fees paid on behalf of the manager or any of its employees to any organization or representative or lobbying group or firm)
ƒ
Professional licensing fees
ƒ
Software to assist with administrative functions (e.g., managing back-office functions, operating systems, word processing)
ƒ Equipment maintenance and repair services
ƒ Analyses of account performance that are used for marketing purposes
ƒ
Proxy services that assist the manager in deciding how to vote proxy ballots
Products or services offered by a proxy service provider that handle the mechanical aspects of voting (e.g., casting, counting, recording and reporting votes)
ELIGIBLE BROKERAGE
ƒ Post-trade matching of trade information
ƒ
Other exchanges of messages among broker-dealers, custodians and institutions related to the trade
ƒ
Electronic communication of allocation instructions between institutions and broker-dealers
ƒ
Routing settlement instructions to custodian banks and brokerdealers’ clearing agents
ƒ
Short-term custody relating to effecting particular transactions in relation to clearance and settlement of the trade
ƒ Comparison services required by SEC or SRO Rules (e.g., use of electronic confirmation and affirmation of institutional trades)
ƒ
Dedicated lines between the broker-dealer and the money manager’s OMS
ƒ Lines between the broker-dealer and OMS operated by a third party vendor
ƒ Dedicated lines providing direct dial-up service between the manger and the trading desk at the broker-dealer
ƒ
Message services used to transmit orders to broker-dealers
ƒ
Trading software used to route orders to market centers
ƒ Software that provides algorithmic trading strategies
ƒ
Software used to transmit orders to direct market access systems
INELIGIBLE BROKERAGE
ƒ Telephones
ƒ
Computer terminals (including those used in connection with
OMS and trading software)
ƒ
Software functionality used for recordkeeping or administrative purposes (e.g., managing portfolios)
ƒ
Quantitative analytical software used to test “what if” scenarios related to adjusting portfolios, asset allocation or portfolio modeling (whether or not provided through OMS)
ƒ Performing compliance tests that analyze information over time to identify unusual patterns (e.g., analysis of quality of brokerage executions), analysis of portfolio turnover rate, analysis of comparative performance of similarly managed accounts
ƒ
Creating trade parameters for compliance with regulatory requirements, prospectus disclosure or investment objectives
ƒ Stress-testing a portfolio under a variety of market conditions or to monitor style drift
ƒ
Trade financing (e.g., stock lending fees), and capital introduction and margin services
ƒ
Error correction trades or related services in connection with errors made by money managers
ƒ
Long-term custody
ƒ
Custodial recordkeeping

STEP I
QUESTION NO. 1: DOES THE PRODUCT OR SERVICE FALL WITHIN
THE STATUTORY LIMITS OF SECTION 28(e)?
STEP 2
QUESTION NO. 2: DOES THE ELIGIBLE PRODUCT OR SERVICE
ACTUALLY PROVIDE LAWFUL AND APPROPRIATE ASSISTANCE IN
THE PERFORMANCE OF THE MANAGER’S INVESTMENT DECISION-
MAKING RESPONSIBILITIES?
Is the product or service in question (i) research services or products; or (ii) brokerage services or products?
RESEARCH
Does the service or product constitute advice, analyses or reports that reflect the expression of reasoning or knowledge?
BROKERAGE
Is the brokerage product or service: (i) required to effect securities transactions; (ii) a function incidental to securities transactions; or
(iii) a service that is required by the rules of the SEC or SRO?
NO YES
NO
The product or service is outside the safe harbor.
YES The product or service is outside the safe harbor.
Does the product or service relate to the execution of the trade from the point at which the money manager communicates with the broker-dealer for the purpose of transmitting an order for execution through the point at which funds or securities are delivered or credited to the advised account?
Subject Matter
Advice: Does the advice relate to the value of securities, the advisability of investing in, purchasing or selling securities, and the availability of securities or purchasers or sellers of securities?
Analyses/Reports: Do the analyses or reports concern issuers, industries, securities, economic factors and trends, portfolio strategy, or the performance of accounts? The product or service is outside the safe harbor.
NO YES
Proceed to Question No. 2
NO YES
The product or service is outside the safe harbor.
STEP 3
The product or service is outside the safe harbor.
Proceed to Question No. 2
Does the manager actually use the item in performing its decision-making responsibilities for accounts over which the manager exercises investment discretion?
NO YES SOMETIMES (MIXED USE)
Proceed to Question No. 3 If the manager uses a research product or service for both research and non-research functions, it must make a reasonable allocation of the cost of the product according to its use (i.e., non-research portion must be paid with hard dollars). Accurate records of allocations must be maintained to make a good faith determination that amount paid in soft dollars was reasonable in relation to value of research product or service received. Proceed to Question No. 3
QUESTION NO. 3: IS THE AMOUNT OF CLIENT
COMMISSIONS PAID REASONABLE IN LIGHT OF
THE VALUE OF PRODUCTS OR SERVICES
PROVIDED BY THE BROKER-DEALER?
NO YES
The product or service is outside the safe harbor.
Is the client commission arrangement a third-party research arrangement or commission sharing arrangement?
NO YES
The product or service is within the safe harbor.
Proceed to Question No. 4
© 2006 Kirkpatrick & Lockhart Nicholson Graham, LLP This is for information purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting with a lawyer
STEP 4
QUESTION NO. 4: IS THE BROKER-DEALER RECEIVING
COMMISSIONS “PROVIDING” BROKERAGE OR RESEARCH
SERVICES? IS THE BROKER-DEALER PROVIDING RESEARCH
INVOLVED IN “EFFECTING” THE TRADE?
“Provided By” Requirement: Does the broker-dealer that effects transactions:
(i) prepare the research directly;
(ii) agree to be financially obligated to pay for the research; or
(iii) pay the research preparer directly and (a) review the description of the services to be paid with client commissions under the safe harbor for red flags that indicate the services are not within Section 28(e) and agree with the manager to use client commissions only to pay for those items that reasonably fall within the safe harbor, and (b) develop and maintain procedures to ensure that research payments are documented and paid for promptly?
NO YES
The product or service is outside the safe harbor.
“Effecting Transactions” Requirement: Does the introducing broker either:
(i) execute, clear or settle the trade, or
(ii) provide 1 of the following 4 core functions and allocates the remaining to a clearing broker: i) be financially responsible to the clearing broker-dealer for all customer trades until the clearing broker-dealer has received payment or securities; (ii) make and/or maintain records relating to its customer trades required by SEC or SRO rules; (iii) monitor and respond to customer comments concerning the trading process; or (iv) generally monitor trades and settlements.
NO YES
The product or service is outside the safe harbor.
The product or service is within the safe harbor.
Records.
Each manager that seeks to avail itself of the Section 28(e) safe harbor must keep adequate books and records concerning products and services obtained with soft dollars.
Disclosures.
Client commission arrangements and transactions should be fully disclosed in each manager’s Form ADV and to the boards of the funds it advises. The SEC intends to propose enhanced disclosure requirements on client commission arrangements at a later time this year.